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European Central Bank WORKING PAPER SERIES LIQUIDITY RISK PREMIA IN UNSECURED INTERBANK MONEY MARKETS

LIQUIDITY RISK PREMIA IN UNSECURED INTERBANK MONEY MARKETS

by Jens Eisenschmidt & and Jens Tapking

http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1025.pdf


The model (presented in this paper) provides a simple explanation for the rise of interest rates in unsecured interbank term money markets in the wake of the financial market turmoil that started in August 2007. It can explain two major observations:

(i) (one-year) unsecured interbank market spreads have significantly exceeded CDS spreads since August 2007 (while overnight interest rate spreads have remained low); and (ii) volumes in unsecured interbank term money markets have reportedly been at extraordinarily low levels since the start of the turmoil while volumes in unsecured overnight markets remained high.

Another observation that fits well to our model refers to the end-of-quarter effects on money market rates during the turmoil. For example the one-month Euribor spread has been clearly higher in the last month of each quarter (in
particular in the last month of 2007) than in other months since the start of the turmoil. Similarly, the one-week Euribor spread has been higher in the last week of each quarter than in other weeks. Our model suggests as a possible explanation a higher risk of liquidity shocks or of a collateral shortage at the end of the quarter so that lending money for a term that ends only after the end of the quarter is particularly risky.

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